Idiosyncratic risk and the equity premium: evidence from the Consumer Expenditure Survey

This paper uses household consumption data to investigate whether uninsurable idiosyncratic risk accounts for the equity premium. The analysis complements and extends prior empirical work by relaxing maintained assumptions about idiosyncratic income shocks. Following Mankiw (1986), the paper develops an equilibrium factor model in which risk premia depend on the covariance between an asset's return and certain moments of the cross-sectional distribution for consumption growth. Cross-sectional consumption factors are constructed using data from the Consumer Expenditure Survey, but they do not appear to be promising candidates for explaining the equity premium. Cross-sectional factors are very weakly correlated with stock returns, and generate equity premia of 1.5 percent or less when preference parameters are set at plausible values.